The Little Essay That Beats the Market

By Joel Greenblatt

I love movies. I hate reading movie reviews. That’s because I don’t like people telling me what to think, plus most reviews merely summarize the plot and give away the ending. That kind of ruins things for me.

Nevertheless, my plan is to ruin things for you. Luckily, we’re not talking about a movie. We’re talking about stock market investing. I’m going to tell you what to think, summarize the basic idea and end with a “magic formula” that can make you a better stock market investor.

So, what should you think? If you want to be a successful stock market investor, you should think about buying pieces of “good” businesses at “bargain” prices. Yes, that sounds simple, but if you actually could find a good business at a bargain price, wouldn’t it make sense to buy it? Doesn’t that sound like an investment strategy that should work!

The only problem is figuring out what’s a “good” business? Well, a “good” business is a business that can earn a high return on capital. What’s that? It’s a pretty simple concept really.

Say you own a store. In my recent book, The Little Book That Beats the Market, we used the example of a gum store (yes, a store that sells only gum–don’t ask!). Anyway, say that store costs $400,000 to build (including inventory, store displays, etc) and last year that store earned $200,000. This works out to a 50% yearly return ($200,000 divided by $400,000) on the initial cost of opening a gum store. This result is often referred to as a 50 percent return on capital. Without knowing much else, earning $200,000 each year from a store that costs $400,000 to build, sounds like a pretty good business.

But what if we compared that to another kind of store, say a store that sells only Broccoli (we called that store, Just Broccoli, for obvious reasons). What if it also costs $400,000 to open a Just Broccoli store? But what if that store only earned $10,000 last year? Earning $10,000 a year from a store that costs $400,000 to build works out to a one-year return of only 2.5 percent, or a 2.5 percent return on capital.

So here’s the tough question. Which sounds better–a business that earns a 50% return on capital or one that earns a 2.5% return on capital? Of course, the answer is obvious. You would rather own a business that earns a high return on capital than one that earns a low return on capital.

So, now we know what “good” is–a business that earns a high return on capital . But what’s cheap? In the book, we defined cheap as a business with a high earnings yield. What’s that? Take two businesses, one earned $300,000 last year, one earned $100,000. Both are for sale for $1 million. If we buy the first, we get an earnings yield of 30% ($300,000 in earnings divided by the $1 million purchase price). The second has an earnings yield of 10% ($100,000 in earnings divided by the $1 million purchase price).

Which is cheaper? All other things being equal, the company that earns more relative to the price we’re paying is cheaper than the one that earns less. In other words, getting a 30% earnings yield is better than a 10% earnings yield–a high earnings yield is better than a low one.

And that’s it. Now you know the “magic formula”! What do I mean? Well, in the book we show that if you just stick to buying “good” companies (those with a high return on capital) but you buy them only when they are available at bargain prices (when they have a high earnings yield), you can more than double the market’s average annual return. And you can do it with very low risk.

Having trouble believing that it’s that easy? Well, how about this? A study we conducted over the last 17 years shows that holding a portfolio of stocks with the best combination of a high earnings yield and a high return on capital produced over 30% annual returns vs. just 12% for the overall market during the same period (see Table 1).

Table 1. The Magic Formula in Action

Magic Formula

Market Average

S&P 500

1988

27.1%

24.8%

16.6%

1989

44.6

18.0

31.7

1990

1.7

(16.1)

(3.1)

1991

70.6

45.6

30.5

1992

32.4

11.4

7.6

1993

17.2

15.9

10.1

1994

22.0

(4.5)

1.3

1995

34.0

29.1

37.6

1996

17.3

14.9

23.0

1997

40.4

16.8

33.4

1998

25.5

(2.0)

28.6

1999

53.0

36.1

21.0

2000

7.9

(16.80)

(9.1)

2001

69.6

11.5

(11.9)

2002

(4.0)

(24.2)

(22.1)

2003

79.9

68.8

28.7

2004

19.3

17.8

10.9

30.8%

12.3%

12.4%

Note: The “market average” return is an equally weighted index of our 3500 stock universe. Each stock in the index contributes equally to the return. The S&P 500 index is a market weighted index of 500 large stocks. Larger stocks (those with the highest market capitalizations) are counted more heavily than smaller stocks.

Over 17 years, earning 30% a year means $11,000 would have turned into over $1 million! Not bad.

But what if we made it even easier for people to follow the magic formula? What if we created a free website–magicformulainvesting.com–that made finding “magic formula” stocks completely automatic? Would that convince you to try it yourself?

Actually, maybe not. With me being such a blabbermouth, if everyone “knows” the “magic formula” maybe it will stop working? After all, how can any strategy keep working if everyone follows it?

Well, here’s the answer. The great thing about the “magic formula” is that it isn’t that great! It doesn’t work all the time. That’s right. Over long periods of time, it’s true, the results are amazing. But…there are still 1, 2 and even 3 years periods when the formula doesn’t work at all! Most people just don’t have the patience or the discipline to stick it out during those tough periods. After a year or two of following a strategy that underperforms the market, most people simply give up!

That means for the “magic formula” to work for you, you must “believe” that the formula makes sense and that it will continue to work over the long term–even if it hasn’t worked for months or even years. For that, you’ll have to understand why the magic formula makes sense. You’ll have to continue to believe that it still makes sense even when friends, experts, the news media, and Mr. Market indicate otherwise. That’s tough to do! Unfortunately, to really “believe”, I mean really, truly “believe”, you’ll have to be convinced that buying above average companies at below average prices actually makes sense. I believe it does. I hope you “believe” too.

If you do, I know you’ll become a more successful investor. But darn if I didn’t just give away the ending.